The Logic Problems That Will Eventually Pop the Bitcoin Bubble

The one fundamental truism of investing, and the one most often ignored, is this: the higher the returns, the higher the risk.

The past is littered with examples of when that rule was ignored. The stocks of dot-com companies raced to stratospheric heights in the late 1990s, until they came crashing to the ground After a decade of astonishing growth in value junk bonds defaulted en masse in 1989. Values in the housing market zoomed for years, until they grew unsteady in 2006 and then collapsed in 2008. The bottom-line message of history is that, if you’re doubling and tripling your money in record time, you’re also more likely to lose it all.

Which brings us to the Bitcoin craze and what is almost certain to be the coming debacle.

For those who don’t know about Bitcoins, they are a brilliant technical concept designed to create a new, digital currency that essentially cuts out the middleman—values of Bitcoins are established online, peer to peer. There are no central banks, and at least for now, there is no government involvement. Like standard currency, Bitcoins can be traded or used for purchases, but only with those sellers who will accept them. Because it is a system independent of external meddling, there can be no sudden devaluation of Bitcoins through the actions of governments. (But make no mistake—there can be sudden devaluation of the currency through the actions of players in the Bitcoin market, and too many of them seem not to realize it. More on that below.) The values are not pegged to any existing currency; instead, members in the Bitcoin market establish the exchange rate through simple supply and demand—when the number of people wanting Bitcoins grows faster than the availability, the values go up.

Most of the discussion and commentary about Bitcoins focuses on the coolness of their creation and the operation of the market. And there is no disputing that those are cool. The currency and the technological means for using it were suggested in 2008 by a person or people who went by the pseudonym Satoshi Nakamoto—to date, no one has discovered Nakamoto’s true identity. (Warning No. 1: If you can’t find out who actually developed a financial instrument, steer clear.) The market became operational in 2009. In order to join the Bitcoin playground, users have to download some open-source software, which is then stored in a digital wallet. (Warning No. 2: If a hacker can steal all of your money by accessing your computer, steer clear.)

The means of conducting the transactions is highly complex—far beyond the scope of any single blog posting—but there are plenty of places online to learn the technical details. Still, one important element that needs to be understood is that the only means of producing more of the currency, and thus increasing the supply, is through operators of systems that validate Bitcoin transactions. These people, known as “miners,” use powerful computers within the Bitcoin network that perform complex mathematical calculations to establish the validity of transactions. The miners do this work voluntarily, but, at certain steps along the way, they are rewarded with 50 newly created Bitcoins. That adds to the available amount of the currency, but the total possible number of Bitcoins is capped at 21 million; there are now 11 million Bitcoins in circulation.

Like I said, very cool. But also very foolish.

The technology, coolness, and intricacy are all beside the point. You don’t have to understand the complexity of collateralized mortgage obligations in the real-estate market—and the fact that they contributed massively to the 2008 economic collapse shows that few people did understand them—to recognize that they are simply financial instruments following the valuation rules that have governed markets throughout history.

Bitcoins are the same—people don’t really recognize them for what they are. Put simply, despite all the hullaballoo, Bitcoins are not a currency, at least in any traditional sense of the word. Rather, they have transformed more into an investment, like a stock. I could certainly purchase items with shares of Google Inc.—I would just have to find a seller willing to accept them—but no one would rationally say that makes stock into a currency rather than an investment.

The essence of a currency is a rational expectation of relatively stable valuation. Yes, values can collapse or soar, but those circumstances relate to unusual events and, for the most part, are widely predictable ahead of time. Outside of those circumstances, the values of valid currencies tend to fluctuate within a reasonable range. There are several reasons for this, including the existence of central banks, which can act to preserve the integrity of their national currency. But more important is the rich and liquid markets for nationally backed currencies, with traders buying and selling based on floating exchange rates. When one currency—say the yen—rises in value against the dollar, a trader might sell it for a profit, then purchase the now cheaper dollar. Or, if, say, the dollar were to start collapsing, the Fed could intervene in the market and purchase quantities of the currency to stabilize it. But it is almost incomprehensible to imagine that 100 yen would be worth $1 on Monday and then be worth $5 on Tuesday. That is the kind of daily value change seen in stocks.

Or in Bitcoins. Last year, the value of Bitcoins more than doubled, from $5 to $13. In other words, assuming Subway accepted Bitcoins (Lord help us), you could have purchased one of the restaurant’s $5 foot-long sandwiches with the value of one Bitcoin unit. By the end of the year, you could have purchased a little bit more than two-and-a-half sandwiches, even though the actual price was the same.

This year, the insanity of Bitcoins is obvious for all to see. Within a few months, the value of Bitcoins soared to a high of $147, an eleven-fold increase. Now that poor Subway restaurant will be turning almost 30 sandwiches for the same number of Bitcoins, with the dollar value of the meal not having budged. In other words, the Bitcoin economy is experiencing massive deflation in the value of assets.

What caused this unprecedented jump, which translates into an annualized return of about 4,000 percent? The general consensus is that the financial crisis in Cyprus, which led to proposals to raid domestic bank accounts, set off a panic among Spaniards, who feared that the tumult would cross the Mediterranean and put their savings at risk. So large numbers of them converted their euros into digital Bitcoins.

But the reason for the price jump is almost irrelevant. What matters here is that the experience shows that the Bitcoin is not functioning like a useful currency. Think about it—would you cash in a share of stock at $13 if the price was zooming up? Or would you wait to see how high the value might go? Principles of smart investing dictate that you should sell when you’ve made reasonable profits, before an inevitable turnaround. Few ever follow those rules, including Bitcoin buyers.

Hoarding has become a common feature of the Bitcoin market, as purchasers hold on to the investment in hopes that the prices will keep rising. One comprehensive study released last October found that more than three-quarters of all Bitcoins—78 percent—had been stuffed into virtual mattresses and taken out of circulation. In other words, in a system where supply and demand dictate prices, the available supply in the market is far less than might be imagined.

In essence, the market is a fantasy. Once the hoarders stop buying, what buyers will step up to the plate to take their place? My bet? No one. There will be, at some point, a time when some hoarder decides to unload. Prices will drop. Other hoarders will get scared and start to sell. Prices will drop further. Before long, there will be a mass rush to the exits. And at that point, the illiquidity of the Bitcoin market will be apparent.

A similar thing even happened to the richest, most liquid investment game of all: the United States stock market. In 1987, the market was creaking a little, and prices started to move downward. At that point, there was a popular idea called program trading, which, at its most basic, would result in sales of stocks if prices fell below a particular level. Of course, when the stock fell, the programs started selling—and all the elephants tried to run through the same door at the same time. Stocks lost 22.6 percent of their value in a single day, simply because there were not enough buyers to offset the flood of selling. That’s exactly what will happen when the hoarders of Bitcoins start to cash in.

Perhaps the best document to understand the Bitcoin market is a report published in October by the European Central Bank. In it, the institution spends a good deal of time critiquing what it calls “the bitcoin scheme.” (Warning No. 3: When a major financial player refers to an investment as being part of a “scheme,” steer clear.)

One of the big problems, the bank writes, is that the Bitcoin investors are on a very uneven playing field, largely because of the complexity that seems so cool. Yes, many markets have investors struggling with different levels of information, but those are usually in liquid markets where such variations will not usually leave one side broke. The bank says of Bitcoins:

The system demonstrates a clear case of information asymmetry. It is complex and therefore not easy for all potential users to understand. At the same time, however, users can easily download the application and start using it even if they do not actually know how the system works and which risk they are actually taking. This fact, where there is clear legal uncertainty and lack of close oversight, leads to a high-risk situation.

Not enough to convince you? Then perhaps Gavin Andresen, a lead developer on the Bitcoin project, might:

Bitcoin is an experiment. Treat it like you would a promising Internet start up company: Maybe it will change the world, but recognize that investing your money or time in new ideas is always risky.

I think Andresen understates the case: Bitcoin is far more dangerous than an Internet start-up company. With a start-up, you can at least see the business plan and assess its probabilities for financial success. Bitcoin is a completely anonymous marketplace. Even assessing how much of the market is held by hoarders requires experts to make analyses.

There are some critics who contend that Bitcoin is a Ponzi scheme, where the initial buyers are simply earning returns with the investments of future buyers. That oversimplified the circumstances—Bitcoin doesn’t actually fit the model of such a scheme.

It does, however, fit the model of one of the most famous investment bubbles in history, the tulip-and-bulb craze. It took place from 1634 to 1637, a few decades after tulips were brought from Turkey to the Dutch. A virus changed the colors of the tulips, making them very popular. Prices began to rise as people bought more and more tulips. Hoarders (the tulip-bulb centers) began loading up on them, driving up the prices as demand increased and supply dropped. Then tulip investors who had huge paper profits decided to lock them in by selling. And the price dropped. Which led to more sales, larger price drops, and on and on. By the time the downward spiral ended, tulips were back to being flowers—not investments—and the bulb investors were wiped out.

In essence, the tulip-bulb bubble was based only on the fact that buyers and sellers decided—peer to peer—that these flowers had ridiculous values. It was nothing more than an agreement in thought. Bitcoin fans admit that the currency has value only because the users in the Bitcoin market think it does but say that that is no different than in the markets for dollars, yen, and other national currencies. And that is absurd. There is no country, no national bank, nothing standing behind the Bitcoin valuations other than other Bitcoin investors. If the dollar falls, the Fed will jump in. And if the Bitcoin falls? Well, personal bankruptcies will probably go up.

So, anyone out there buying Bitcoins at ridiculously inflated prices, please recognize the risk you are taking. You will likely lose everything.

Besides, if you sell now, maybe you can go to the garden store and buy some tulips.